“If everyone is thinking alike, then somebody isn’t thinking.” – (George Smith Patton, Jr., 1885-1945, general in the United States Army)
As discussed in our latest performance update, we are convinced that active management will deliver value-add throughout time for the patient investor. We are well aware that there are many different pathways to success. In order to be a successful investor, we integrated our convictions as well as the resulting conclusions into our investment process. Bottom-up, systematic, fundamental investors in general and especially value investors require a sound intellectual framework. Therefore we wanted not only to share some of our core beliefs but also some thoughts every investor is well-advised to consider:
1. Starting point of valuation is the best predictor of future excess returns:
over the long-term, valuations will drive stock returns by anchoring market prices, sooner or later, to the hard reality of cash flows. In the short-term, prices can be driven by the changes in market expectations and their level of uncertainty driven by emotion. It remains uncertain whether these expectations materialize or not. If a business fails to deliver what was already implied, the market will, sooner or later, reclaim all excess returns earned; potentially even exaggerating in the opposite direction. Paying a high valuation for a stock translates either into a willingness to accept lower future returns or acknowledging to have special insights about the company’s particular path in a very complex future. Most of the time more events will occur than we ever thought. Just think about the last 10 years and all the changes that have happened around us. No business can ever be good enough to be attractive at any price. In addition “bad” companies undervalued by the market can offer attractive future returns. As value investor, buying good things is far less important than buying things at an attractive valuation.
Valuation is what predetermines future returns. At today’s valuation of the US-Market, paying almost 23 times current earnings, investors seem to be expecting a bright future for a very long time. Alternatively, they might be willing to demand less reward for the bearing the risk of holding these companies. After the global financial crisis, the US market was priced at 13 times earnings (at depressed levels) allowing much more space for attractive future performance. There are times when investors seemingly ignore that fundamentals matter and that, by definition, cycles repeat themselves.
Bottom line: Valuation is the ultimate determinant of future performance – not the other way around.
2. Mean Reversion
Mean Reversion as well as cycles come in all shapes of forms, are an important source of mispricing, and provide the foundation for value investing. The concept of reversion to the mean is one of the critical elements that are driving cycles. It basically says that a positive or negative outcome that is far from average will be followed by an outcome with an expected value closer to the average.
This is far more than a statistical concept. In the “real” business world, were humans are interacting, this translates in never-ending ups and downs of rational as well as emotional and less rational swings. For businesses or sectors mean reversion comes in the form of competition and economic cycles. For example: Businesses with high returns on capital attract fierce competition. On the other hand companies in trouble can, out of necessity, gain the strength to re-invent themselves to adjust or become obsolete. Patterns like these become more frequent in dynamically fast moving markets and product cycles. Therefore, we should not expect super high margin business to stay that way, in particular as most asset light businesses have rather low capital requirements.
Nothing in life nor investing is perfectly linear; not only changes of economic cycles and competition are defining the alteration of multiples paid. Amongst others, taxes, inflation and further external factors impact the multiple the market requests. On top of the cycles in businesses, sectors and countries, investors act under the influence of fear or greed driven by the perceived level of uncertainty associated with decisions. Extrapolation of results at the climax or low of cycles provides a fertile ground for mispricings. As prices for businesses, which constantly undergo cycles, are set by investors, it becomes challenging to separate reasons from emotions. Emotional swings can set, reinforce or reverse trends. Even value investing as such is mean reverting, as a result of the markets´ performance chasing habit.
Bottom line: Trees don´t grow to heaven. In this cyclical world, meeting high expectations far in the future is very uncertain. Therefore prudence, a conservative approach and the price paid becomes more evident for investors like us.
3. Past performance is a terrible indicator for future performance.
One of the largest misconceptions of investors is to take the broad opinion about something (e.g. exceptional performance) and to extrapolate this trend into the future. In fact, performance (without fundamental support) has rather borrowed returns of the future and therefore a below-average upcoming performance is more likely. This concept is very in-line with mean reversion and agency risk. Just think of all the returns of famous investors and their funds. Peter Lynch, one of the best fund managers of all time, had returns of 29% p.a. compared to the average investor in the fund of 5% over a time period from 1977 to 1990. We should not invest in a fund (nor a stock) because it performs well but rather because the investment process is sound and built on a fundamental foundation which is repeatable.
Bottom line: Trend-chasing is dangerous. Past performance without fundamental reasoning already borrowed tomorrow’s returns.
Uncertainty persists, as investment decisions are always dealing with the future, which by definition is uncertain. Riskier investments, with greater uncertainty, offer higher prospect returns in order to attract capital, which does not mean they have to materialize; if they were able to guarantee higher returns, they would not be risky at all. Risk is paradox when we look at it from a value investor‘s point of view. At times of the highest perceived certainty, valuations are also high, resulting in low returns. Investors often strive for certainty for a perceived feeling to have things firmly under control. At times when uncertainty has disappeared, it is most likely that prices have been rising as well as the price for bearing the risk of uncertainty has been driven out of the stocks.
Bottom line: Uncertainty offers fertile soil for attractive investments. But look for low prices and a wide margin of safety as compensation.
Emotions, cognitive biases, herd-like behaviour are reasons mispricings are constantly being created in the market, giving others the opportunity to gain from these over/under reactions. It would be foolish to assume that we are any different than the crowd when it comes to biases and emotional swings. Benjamin Graham, referred to as the father of value investing, wrote: "The investor's chief problem—and even his worst enemy—is likely to be himself". The pendulum of investment psychology is constantly fluctuating between optimism and pessimism, between greed and fear, between risk tolerance and risk aversion. Investors rarely learn the lessons of history. It is part of the human psychology to ignore the past and believe that “this time it’s different”. However, the key is that history is simply a guide to the future. Therefore every investor needs a process to keep his/her emotions at bay and distinguish reasons from emotions. As one of the most important strengths of an investor should be psychology as detailed know-how and understanding of accounting and economics have been becoming a commodity in this competitive field.
How you deal with great certainty and great uncertainty will have tremendous impact on your investment results in the long-run. Learning about ones weaknesses and strengths is key to investing as it involves a healthy dose of self criticism.
Bottom line: We stick to our investment process to protect ourselves from falling victim to our own emotional swings.
Patience is and will always be a cornerstone of every value investor. As Benjamin Graham wrote: “Undervaluation caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by over-enthusiasm or artificial stimulants.” In the short-run patience but also discipline will make you look irrational and cut off from reality. Even though valuations will drive stock returns, you have to be cognizant that you will not always get reward immediately. Quite on the contrary, it might take a very long time, causing doubts about the validity of your decision.
This is not only true for single investments. Value investing too, demands a great deal of patience from investors and clients. It does not work on a weekly basis, nor on monthly or even yearly. But it works over time albeit irregular. If it were to work permanently, the alpha would be arbitraged away by the market.
Bottom line: Value investing works in the long-run. Be patient and you will be rewarded.
7. To be Contrarian
To be Contrarian is by far not to be equated with being right. A Value Investor is not the equivalent of buying cheap, rather are his positions often contrarian; on the other hand, not every contrarian is a value investor. Market participants often think about the same asset the same way. As fear rises, investors start looking for alternatives involving less uncertainty, pushing valuations lower. Being contrarian means seeking value by looking where no one is looking. It includes behaving counter-cyclical and act when others are fearful.
To be contrarian sounds easy in theory. But it is inherently difficult to be contrarian because it’s unpopular by definition, counter-intuitive and potentially unglamorous to contradict the general opinion among market participants. It requires you to challenge conventional wisdom, go against the wind and stand apart from the crowd. This means that very often you will be moving in the opposite direction of everybody else which can be terrifying at times. It requires that you make decisions which others will mock you for when buying the unloved stocks.
Therefore the challenge is not only to stand against the crowd, but also to prove to be right to do so. The irony is that, in the investment world, ones success or failure in no way affects the outcome of the next investment. We must make the right investment for the right reasons as well, otherwise, successes are random and largely attributable to luck. Nevertheless following a value approach, as we do, leads you to being contrarian at times, as Sir John Templeton properly said, “If you want to have better performance than the crowd, you must do things differently than the crowd.”
Bottom line: To be contrarian is easy in theory but difficult in practice. Our investment process supports us to strengthen our conviction when needed most.
8. Correct forecasts
Correct forecasts often come from trends, which have already been discounted. A stock that achieves what has been priced in already, did not generate excess returns based on achieving the forecast but based on something else. It doesn’t matter what you know, but what you know that the market doesn’t know. This needs to be captured in a process. A forecast therefore can also be only less wrong than the market in order to be successful.
There are no facts available about the future, for none of us, not even so called experts. Many investors highly value experts‘ advice, but economic developments, markets, currencies and interest rates are not the result of a scientific process but rather made by humans acting in the market. Therefore experts are not likely to be right all the time, what is often sold as close to a fact, in the end is just their opinion. Even if those “opinions” about the future often sound too appealing to trust, they are far from sure to come true. The polls for the elections held in 2016 (Brexit, Trump) gave a glimpse how wrong experts can be.
Many analyst and investors seem to think “knowledge” and outlook to upcoming central bank decisions, interest rate changes, government actions, movements of currency and markets will lead them to investment success. But, those who invest in this top-down fashion need to be right not only about market direction, but also about the magnitude, path and timing of each market trend. Hence it seems far easier to be right about the value of specific companies than to make accurate macroeconomic assessments.
Bottom line: Relying on forecasts is hazardous as they are rather opinions than a reliable look ahead into the future.
9. News are dangerous
News are dangerous: Investigative journalism is a basic prerequisite for our society. Politicians, institutions and public matters need someone to look over their shoulders and uncover when something goes horribly wrong.
The news considered to be dangerous is the one which does not require thinking. Mostly it is trivial and irrelevant, even though the media suggests the opposite. Bad news and stories are a business case produced to sell paper, but by no means sure to materialize. As humans are not immune to front pages full of stories about economic collapse, Brexit and plane crashes, constantly being exposed to news may change our risk attitude. As emotional elements are gaining dominance, rational and probabilities shift to the background.
Constantly following news gives people the hazardous feeling of being informed, and as a consequence act more confident as they are seemingly knowledgeable. Journalists, even if we falsely attribute them more know-how, have generally no more insight than the rest of us. News has no explanatory power. Therefore news do not offer the competitive advantage hoped for, but rather the opposite. As humans we tend to consume media the wrong way, to confirm beliefs, not to challenge them. Warren Buffet once said:” What the human being is best at doing is interpreting all new information so that their prior conclusions remain intact.” As the confirmation bias is further reinforced we are encouraged to act accordingly. As the opinion is often based on no-special-insight without explanatory power, it is potentially dangerous and may lead to misjudgements. A healthy dose of scepticism is vital for a successful investor. News do have other incentives than to deliver investors with useful insight but to produce stories that sell. They might lead you on the wrong track and worst of all disturb your independent thinking, killing your creativity, putting on your blinders and distract you from focusing on your core competence.
“Too often we enjoy the comfort of opinion without the discomfort of thought.” - (John Fitzgerald Kennedy, 1917 – 1963, 35th President of the United States)
Bottom line: Do not confuse news with facts. Rather rely on in-depth research, your competitive advantages and convictions.
“…it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism…. For it is in the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” - J.M. Keynes.
When markets or better said performance isn’t going your way, what kind of asset managers (or asset classes, or even securities) will individuals, banks, boards, and committees choose to keep investing in? It is our belief that a lack of conviction in investment choices by most individuals and managers, and the corresponding constraints on the institutions governed by such individuals, provide and therefore enable the successful exploitation of mispricings that can be expected to correct over unknown and potentially long horizons. Conviction provides you with the power to think differently and gives you the strength to stick to your process during drought periods (which is as sure as eggs is eggs). A process should reach the same quality of investment decisions on Tuesday as on Friday, at Eastern and at Christmas, in up and down market as well as at times being ahead or behind the benchmark. To be able to build up conviction, you need to have a fundamentally solid investment philosophy, a well thought through process, reinforced by research proven by appealing results. A solid conviction is not optional, but necessary for long-term success of an investor. Nevertheless it is a double-edged sword. In order to be successful your conviction must be strong enough to resist the temptation to change under persistent headwinds. This is not meant to lead to blind stubbornness as from time to time you need the modesty to accept that the process could be wrong and act accordingly.
Bottom line: Without conviction, you will inevitable repeatedly fall back to positions in tune with the consensus, resulting in average returns.
All thoughts mentioned are vital to be considered by an investor. We at Lingohr & Partner have integrated our convictions and the resulting conclusions into our investment process. As an independent asset manager we have the freedom to follow our beliefs, think independently, be contrarian at times and manage not just to focus on quarterly outcomes. On the one side our systematic process serves for identifying value opportunities and attempts to take indiscriminate advantage of human misjudgement. On the other side it is built to protect ourselves from falling for misjudgements too. This gives us the unique opportunity to exploit the alpha other market participants are not managing to grasp. We believe in our long-term proven process, focusing on finding bargains and combining factors into models which make conceptual and fundamental sense. One of the keys to our long-term investment success is hard work, great patience, strict discipline and maintaining your conviction. At Lingohr & Partner, we always stay disciplined and stick to our approach, especially during periods of headwinds.
Lingohr & Partner Asset Management GmbH is a financial services institution as defined by the German Banking Act and is subject to supervision through the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht - BaFin). Its registered office is in Erkrath, Germany.
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Past performance of financial instruments is no guarantee of future results.
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